Monday, October 22, 2012

Would Warren Buffett buy green pieces of paper?

Noah Smith has an interesting post in which he asks: "Is money fundamentally worth nothing more than the paper it's printed on?"

He goes into some soul searching on the definition of "fundamental." His concern with definitions is helpful. The recent debt super-debate was largely blown out proportion due to definitional differences, in my opinion.

If anyone is worthy of describing the word fundamental, it's the sage of Omaha. In deciding whether to purchase a stock or not, Warren Buffett conceptualizes the problem by imagining that he'll never be able to sell it again. He's stuck with it forever. If you abstract from an asset's ability to be exchanged onwards, what you're left with is pure fundamental value. This applies to commodities and consumer goods as well as it does to financial assets.

The definition of fundamental having been dealt with, we're left with a thorny problem. The word money is still undefined. As Neil Wallace pointed out, "monetary theories should not contain an undefined object labeled money." Is Noah talking about gold, cattle, gold-backed bank notes, bitcoin, yap stones, Federal Reserve notes?

In nomadic societies, cattle were highly liquid. What was a cow's fundamental value? Assume that it could never be exchanged again. What remains is the cow's fundamental value — it might be eaten, it could be used to make clothing, it can help rear more cows, it can help in the fields etc. Take another form of "money". In the 1800s, most bank notes were issued with gold redemption clauses. What was a gold-backed bank note's fundamental value? Assume that a note can never be exchanged onwards, and you're left with a security with some fine print on it that says that the issuing bank will redeem it for gold. Its fundamental value is the value of the underlying metal.

I'm going to assume that by green pieces of paper, Noah is specifically interested in the fundamental value of fiat money, perhaps Federal Reserve notes. Assume that a specific FR note, say the one in your wallet, can never be exchanged onwards. What is it worth?

This isn't an economic question. It's a question of security analysis. What does the fine print of your FR Note say? FR notes are liabilities of the Federal Reserve. They carry a "first and paramount lien" on the assets of the Federal Reserve. Having a first lien means that an FR note holder ranks higher than all other Federal Reserve creditors. In other words, your note is an excellent claim. What are the Fed's assets? They have a bunch of government bonds, some gold,* and a few foreign currency denominated assets. These assets aren't paid out on demand. Rather, as a note holder you'd have to wait for the Federal Reserve to be wound up before you could get their hands on these assets. So the fundamental value of an non-exchangeable FR note is the distant possibility that the note holder gets to exercise their senior claim on underlying Federal Reserve assets. That possibility is worth some non-zero value.

This all reminds me of an old conversation I had with Nick Rowe. See here. In that conversation, Nick uses the same Buffetian concept of fundamental value as I use in this post, and argues that fiat money has no fundamental value. I argue the opposite.

Ok, that's my answer to Noah's question.

An interesting thought game is to consider what would happen if all FR notes are no longer exchangable. Say that for some reason or other, no one will accept notes anymore. The price of FR notes would immediately plunge towards their fundamental value. But a large component of a note's fundamental value is derived from the underlying value of the bonds which the Fed holds on its balance sheet. Because these bonds promise to pay a fixed quantity of dollars, the bonds themselves would simultaneously plunge in value along with the notes. And as the bonds plunge in value, the notes do too. And as the notes fall in value, the bonds plunge again etc. etc. until they both spiral to zero.

What halts this spiral is that the Fed holds more than just nominal bonds. It also owns some US dollar assets that pay an inflation-linked return, namely Treasury Inflations Protected notes. At the same time they hold gold. Lastly, they hold foreign denominated bonds whose value would be protected. At some much lower price for FR notes, the Warren Buffetts of the world calculate that the value of a note's senior claim on gold, TIPS, and forex is probably worth more than the market price of notes, and they step in to buy. The death spiral ends.

*the Fed doesn't actually own gold. It owns claims to gold. See this article.

7 comments:

I'm here because I followed the link you posted on DeLong's blog. A few comments:

1) If I accepted your definition of 'fundamental' then the only things with fundamental value are potable water and ammunition. I don't accept your definition of fundamental value.

2) Buffett's goal is to make money. The purpose of Federal Reserve notes is to enable transactions. (Brad and many others have pointed out the benefits of money more eloquently that I can here.)

3) I have never exchanged an FR note for a Fed asset. I have no interest in exchanging FR notes for underlying assets, whatever those might be. If I were forced to exchange a FR note for an underlying asset I believe I would be very unhappy about it.

4) I do not expect that I will ever be in a position of having to exchange an FR note for an Fed asset. In fact, I don't believe I know anyone who's ever expressed any interest in exchanging a FR note for the assets which support it.

5) "An interesting thought game is to consider what would happen if all FR notes are no longer exchangable." No, it's not interesting at all. Sure, we could all choose to treat FR notes as near-worthless pieces of green paper. Or we could all choose to shoot ourselves in the head. But most of us don't choose to do either and the underlying reasons aren't particularly interesting in either case. More interesting perhaps is why someone would choose to treat perfectly useful FR notes as near-worthless pieces of green paper - or choose to shoot oneself in the head. What is the benefit which would be achieved?

No, the only things with fundamental value will not be potable water and ammunition. If you can never sell your house, for instance, then it loses any premium it earned from its exchangeability. All that remains is its fundamental value: you can live in your house, you work in it, etc. Same with your car. If you can't sell it, then its value collapses to its fundamental value: you can drive it, you can carry stuff in it etc.

Of course you've never exchanged FR notes for assets! Neither have I. We've never had to consider the possibility that we might be stuck with FR notes because notes can always be passed off in the open market. That's the whole point of the above exercise. If you can't pass off FR notes anymore, how might you choose to value the FR notes in your pocket? Stephen Williamson and Krugman think it would be worthless, I disagree.

Fair points. (And, as no doubt you perceived, I was giving you some flak above.) Things can have 'fundamental value' even if they don't have monetary value. The issue I have with the exercise is that it seems to me if you can't pass off FR notes on the open market anymore then the fact that you can't is probably the least of your problems. What must the world look like if you can't pass off FR notes as currency? I might have a "first and paramount lien" on the assets of the Fed but I suspect that if I were in the position of having to exercise that lien then the steps I'd have to take to do so would be very ugly.